After months of tussling, Republicans and Democrats on December 18 reached agreement to extend income tax cuts enacted in 2001 and 2003. Important for investors, the maximum 15 percent federal tax rates on capital gains and dividends will now be with us for at least the next two years.
What came as a surprise in the compromise were changes to the estate and gift tax laws. Many had assumed Congress would divorce the changes in estate and gift taxes from any extension of the so-called Bush tax cuts.
In 2001, Congress created a set of time bombs in the tax rules applying at death. One of the bombs went off on January 1, 2010, as the estate tax went away but those inheriting assets were faced with a monster called “carryover basis” (see “The Coming Train Wreck,” Wealth Wise, Best Of the North Bay 2007). The second time bomb was set to detonate on January 1, 2011, when the estate tax was scheduled to rise from the dead in its 2001 form, taking us back to a $1 million exclusion and a 55 percent tax rate.
These ticking time bombs generated huge uncertainties for estate planners and their clients—indeed, estate planning had become more like “estate guessing.” While the estate and gift taxes were supposed to apply only to the “rich,” the possibility of returning to a $1 million exclusion meant some pretty ordinary folks were well advised to engage in some fairly complicated tax planning.
For nine years, Congress irresponsibly avoided resolving these uncertainties. So I was surprised to find important estate tax changes in the compromise that Congressional Republicans were able to extract from President Obama. Of course, like the income tax provisions, the new estate tax rules only apply in 2011 and 2012. However, there will be little incentive in the new Senate (and none in the new House) to backtrack from these “temporary” changes.
The most important new provisions are a $5 million exclusion from estate tax and a maximum tax rate of 35 percent (up from $3.5 million and down from 45 percent, respectively, in 2009). But some other noteworthy changes are even more surprising. First among the new provisions is “portability” of the $5 million exclusion between spouses. For many decades, the exclusion was personal to each spouse. If one didn’t use it, it was lost to the other.
The standard planning solution to this problem was the “Bypass Trust” (also called an “Exemption Trust” or “Credit-Shelter Trust”). To take full advantage of the exclusion, the first spouse to die would set up a trust funded to the maximum available exclusion amount. The surviving spouse would typically be the primary beneficiary of the Bypass Trust and, more often than not, the trustee. For most surviving spouses, a Bypass Trust could be administered in a way that felt not much different from inheriting the deceased spouse’s share of assets outright.
Now, the executor can transfer to the surviving spouse the unused portion of the deceased spouse’s exclusion. It will remain just as important to take action after the death of the first spouse to preserve the exclusion as it did with the Bypass Trust system.
The second unexpected provision “reunifies” the estate and gift tax systems. Until 2001, the same exclusion from tax applied to transfers, whether made while alive or after death. The estate tax and gift tax became decoupled in 2001. While the estate tax exclusion increased in steps to $3.5 million in 2009, the gift tax exclusion remained at $1 million. Now gifts totaling less than $5 million per donor won’t be subject to tax.
A third, very welcome, change is that the estate and gift tax exclusion will be indexed for inflation, beginning in 2012. In previous legislation, the exclusion either remained fixed or rose in steps to a maximum. Assuming the newly passed legislation remains on the books, the exclusion will automatically rise along with inflation. (If Congress thought it was passing a two-year tax law, why include an indexing provision with an indefinite life expectancy?)
One not surprising but still very welcome provision is the repeal of “carryover basis” applicable to those dying in 2010. A taxpayer who sells an asset deducts the “cost basis” from the sales proceeds to determine the amount of gain subject to tax. Until December 31, 2009, one inheriting property was able to increase, or “step up,” the cost basis to the value at the date of death. Under a carryover basis system, the cost basis of the property in the decedent’s hands was “carried over” to the inheritor. Carryover basis is a record keeping nightmare, because the IRS places the burden on the taxpayer to provide evidence that their cost basis is something greater than zero.
Thankfully, carryover basis goes away January 1, 2011, hopefully never to be resurrected again. Once again, estates and inheritors will have a new basis in inherited assets equal to the value at the date of death. Estates of those dying in 2010 can elect either to be taxed under the new law and get a new basis at death or follow the 2010 rules, which allowed certain upward adjustments to cost basis.
While I welcome the 2010 changes removing millions of people as potential targets of the estate tax, I remain firm in my opinion that the whole death tax system should be junked. One who inherits property can either spend it, save it or invest it. All three are socially beneficial. Having the government confiscate a portion in the name of “fairness” simply transfers to the political process the decision of how money is spent, saved or invested. Given amply demonstrated governmental foolishness in such matters, I’ll take individual decisions any day.
